The Economy

The Ultimate Bubble?

At a lavish conference in Monaco, the game was guessing which big private-equity firm will be first to go bust. But the smoke and mirrors that wrecked the global economy might actually save the likes of K.K.R. and Blackstone.

Now you see it: Blackstone’s Stephen Schwarzman and K.K.R.’s Henry Kravis. Photo illustration by John Corbitt.

Here’s a parlor game, played best by the people who are in it: Which private-equity firm’s going bust first? Carlyle? Fortress? K.K.R.? Cerberus? Apollo? Could it even be mighty Blackstone, with its vast real-estate holdings? Which of these one-word-branded enterprises (the word should emphasize strength, opacity, and preferably be culled from mythology—though no one in private equity, rest assured, reads his Bulfinch’s) that make up what’s been called the world’s “shadow banking system” will collapse and, in the domino pattern of this financial crisis, take the other firms with it?

There’s an urgency to this question because no big firm has actually gone bust—yet. All of the behemoth investment groups that sit on top of trillions of dollars of the largest capital accumulation outside the public markets remain suspended over the global economy like awfully big shoes waiting to drop. The wait increases both the suspense and the bitchiness of the game: somehow every private-equity guy (private-equity guys have been among the most unpopular figures of the great bubble) feels he’s been more prudent and responsible than all the others. Given the credit crunch, no private-equity deals are getting done now—chances are that what you’re doing with your idle hours as a P.E. man is trying to figure out who deserves to crash and burn before you.

More Michael Wolff on VF.com. Photograph by Mark Schäfer.

For reasons that, at this particular moment in economic time, make little sense—and border on the totally embarrassing—I was in Monaco recently at a business conference that attracted many private-equity types who are still traveling grandly on the 2 percent fees private-equity firms pay themselves on the money they’ve raised. At my table in the ballroom of the Hôtel de Paris, in Monte Carlo, at a dinner hosted by Prince Albert of Monaco, there was a gentleman whose company, backed by private equity, had gone public and risen to $130 a share, but had, through the terrible autumn, dropped to $17. To my left there was a gentleman from K.K.R.—the seminal name in the corporate-buyout business, having survived and profited off a quarter-century’s worth of bubbles and busts. Actually, the gentleman joined K.K.R. after the collapse of Lehman Brothers, where he had been for many years. (By my quick calculation, in all that time of being compensated with Lehman stock, he probably lost between $30 and $120 million in the collapse. Still, he seemed to have homes in London, Dubai, and New York.) I asked, lowering my voice, “So … who’s on the brink?”

“Carlyle,” he responded darkly. Indeed, Carlyle Capital Corporation, the arm of the Carlyle Group that invests in mortgage-backed securities, had defaulted last spring on more than $16 billion.

The gentleman on my other side was Norman Pearlstine, the former editor in chief of Time Inc., who’d gone to Carlyle, it was widely assumed, to lead a buyout of Time, but who had recently forsaken his adventure in private equity and gone back into the news business—this time as the chief content officer at Bloomberg.

Still another gentleman of my acquaintance, at an adjacent table to which I shortly hopped—a European manager of private-equity money, who’d taken in nearly a billion dollars in new investments just before the bubble burst—said in response to my question about the brink, “Oh, it’s K.K.R. who’s going to go over quickly.” (I briefly thought of the K.K.R. man, having left Lehman and now with the prospect of going down on a second Titanic—that must keep you up at night, even in London, Dubai, and New York.)

“Well, who is O.K.?”

“If you have cash—if you’re not fully invested.”

“You’re O.K. if you have cash?”

“Well, I wouldn’t go that far.”

“But if you are fully invested?”

“Oh, dead.”

And yet, it seemed important to contrast the existential predicament of private-equity funds—the most debt-ridden enterprises in the history of finance, with some $4 trillion due to lenders in the next year (it is mathematically impossible, given the downturn, for even a fraction of that to be paid back in a timely fashion)—with the fact we were sitting here in Monaco, in a scene that might well have occurred at the very top of the market. To the naked eye, nothing had changed.

When I was 11, my father, a businessman who, in his day, took a dubious risk or two, gave me a key lesson in finance and life which I knew was meaningful without understanding it. “You’re not bankrupt,” he said, “until people know you’re bankrupt.”

By which he meant, I’ve come to understand, that money is a complicated reality. It’s a master illusionist’s game. The artifice is everything. Transparency is the enemy of making it really big—which is one reason the word “private” got joined to “equity.”

This may have something to do with the message I got when I called up Stephen Schwarzman, the head of the Blackstone Group, and the most successful of all private- equity players. At the top of the market, in June 2007, when Blackstone went public (a top-of-the-market irony was to have firms specializing in taking companies private doing it with public money), he was, briefly, the richest man in New York, stepping over Michael Bloomberg, but now may be down to his last billion.

This might seem to be a sort of going to ground, or holing up in a single room, as you are surrounded by creditors and police, the gun in your hand. Blackstone, which with Fortress Investment Group went public a year and a half ago, is now at a fraction of its former value—whereas K.K.R. has altogether failed in its efforts to go public.

And those other kinds of funds, hedge funds—which make short-term investments in securities rather than, like private-equity funds, long-term investments in companies—are, everywhere, shutting their doors. Investors in those funds are, sensibly, demanding their money back—or what’s left of it.

And yet, even though you might not be able to get through to Mr. Schwarzman, the greater point is that he is still in his office. His thousand or so employees around the world are still there, too. Indeed, few people in private equity—in the middle of the greatest financial crisis of the era, even as everybody in private equity awaits the collapse of everyone else in private equity—have actually lost their jobs. Even with no business to be done, it’s business as usual. This is an extraordinary demonstration of denial, or of a dreamworld, or of an alternative reality—or of my father’s dictum. Nobody knows if the world’s great P.E. firms are out of business—the guys who run these firms may not even know.

No cheap trick: Carlyle’s David Rubenstein and Quadrangle’s Steve Rattner. Photo illustration by John Corbitt.

In the finance world in recent years, to work at an investment bank, to be part of the great, well-paid army of people who service financial transactions, was to be a schlub. A relative zero. A body. The brains were creating their own equity and growing it. The guys at Lehman and Bear Stearns deserved in a sense to lose their jobs because, well, they weren’t in private equity—weren’t bright enough or farsighted enough to be. In a never-ending re-invention of relative masters of the universe, it was private-equity guys who came to sit on top: David Rubenstein, at the Carlyle Group; Blackstone’s Schwarzman; K.K.R.’s Henry Kravis; T.P.G.’s David Bonderman; Quadrangle Group’s Steven Rattner. These are the master illusionists, the guys who combined social skills and salesman talents and media savvy and quickness with numbers and expensive suits to make vast personal fortunes and to redefine the craft or magic of modern finance.

But remember: histories of financial collapses are as much about who holds on to their money, or even who profits from the mess, as about who loses it. Nobody remembers my grandfather, who lost his fortune (in the cereal business) in 1932. Everybody remembers Joseph Kennedy, who held on to his and, given the great opportunities when you’re the only one with money, vastly grew it during the Depression.

Indeed, if the private-equity business is, by all logic, looking at imminent catastrophe and ruination, it can also see the best possible environment in our time for investing—a world in which sound and necessary businesses have lost two-thirds or more of their value, a world in which public companies can be bought up by private money for a pittance. This is heaven on earth for the brave and the greedy.

It is also, in fact, the very model of private equity. Most of the powerhouse firms that, in the last five or six years, have come to dominate the corporate world were firms that found themselves with money in the bank when the market collapsed in 2001. In the private-equity formula, a $2 billion company which, at the bottom of the market, had lost half of its value—making it a $1 billion company—could be bought with $100 million in cash and $900 million in debt. When the market rebounded, and the company’s value was restored, the private-equity firm, taking a billion in profit, would have a 1,000 percent return on its investment, keeping 20 percent of the profit for its troubles. (That’s 2-and-20 in private-equity parlance—2 percent annual fee on the money that’s been raised; 20 percent of any profit.) Since private-equity money is raised on the basis of how well your last deal (or last fund) performed, this became self-perpetuating—big returns got you more money. (The more you borrowed, the bigger your returns would be.)

This moment might be like that—vast private-equity funds eyeing, across the commercial landscape, nothing but devalued properties.

Except that, as much as that is the case, it is not the same at all.

Rubenstein, Kravis, Bonderman, Rattner, and Schwarzman, holed up in his office, could still—with many of us taking great satisfaction in this—go bankrupt.

For one thing, the modus operandi and reason for being of private equity is borrowed money, and there is none to be had— zilch. Gone. Even Schwarzman, practically speaking, can’t get a loan.

For another, while firms have raised vast pools of capital—the success of a firm is judged largely on the amount of money it has raised—this capital is not actually in the bank. It’s “on call”—and it’s entirely unclear what happens if, for instance, the Carlyle Group, with $40 billion theoretically available, calls on someone (wealthy individual, pension fund, well-endowed university, or, in that hall-of-mirrors locution, a fund of funds) who has lost the will or wherewithal to meet the call. (Permira, the big U.K. P.E. fund, has voluntarily let some investors take money back.)

And, perhaps most important, the very premise on which a P.E. fund buys an asset—that is, a reasonable ability to ascertain its current value—is gone. Nobody knows what anything is worth—therefore you’d be a fool to buy it.

This last point is, unfortunately, germane not only to what you buy but also to what you own.

To wit: private-equity firms now own all these businesses which not only have dramatically declined in value but are, practically speaking, worthless—their value doesn’t exceed their debt. What’s more, as consumer spending plunges, there isn’t enough business to support the debt.

Quadrangle, Rattner’s firm, which specializes in media deals, bought Maxim magazine for $250 million a year ago—borrowing most of the money to do the deal. This was already a deal burdened by the hubris of private equity—that is, the company that owned the magazine (and specialized in publishing magazines) was unloading it precisely because it understood the market for laddie magazines had peaked (a year before, the company had spurned a much higher offer). But Quadrangle, even though it had no experience in the publishing business, assumed that with its business prowess (P.E. types who seldom have managed anything nevertheless believe themselves to be consummate managers) it could cut costs and raise cash flow and expand into new lines of business—Quadrangle envisioned Maxim-themed movies and restaurants and tchotchke shops. This general hubris and belief in business prowess come because, while P.E. firms have so often been Keystone Kop sorts of managers, the economy has over and over again proved their competence. Or, at any rate, the rising economy meant that all sorts of mistakes would be covered by a rich resale price. In a sense, with the market constantly rising, you could do nothing wrong—until now. Accordingly, the Maxim business went from making $28 million to making $8 million annually, which is not enough to pay the costs of the debt it incurred. Hence, Quadrangle Group, which recently admitted defeat and closed its hedge-fund arm (sometimes called, confusingly, the Quadrangle Fund, which, when I was in Monaco, meant that a rumor swept the Hôtel de Paris that Quadrangle itself had collapsed), is now trying to give Maxim back to its creditors.

At Apollo, Leon Black’s troubled firm, they’ve lost $365 million on Linens ‘n Things. And they’re in trouble with more than $3 billion in other investments.

And Blackstone, at the top of the market—indeed doing the last big deal of the bull market—paid $26 billion for Hilton Hotels. (Hotels, where private-equity guys spend most of their time, form a big part of the P.E. mythology. Not only has Blackstone become the biggest hotelier in the world, owning at various times mass-market chains such as La Quinta and Extended Stay America as well as Claridge’s, in London—reportedly Mr. Schwarzman’s favorite home away from home—but the Carlyle Group is named after the Carlyle Hotel in New York, David Rubenstein’s favorite hotel.) Actually, Lehman Brothers, Bear Stearns, and a few other banks paid $26 billion for Hilton—they lent Blackstone the money. Or, in fact, because Lehman and Bear have collapsed and their debts have been bailed out by the U.S. government, you’ve paid for the Hilton hotels—with their dramatically devalued real estate on which their empty rooms sit.

This is bad. Private equity is in no better position than any bank or hedge fund or insurance company which has seen the values of its holdings collapse.

It would seem unfair then, to say the least, that this very situation that has brought the world to the brink of ruin—financial schemes founded on artifice and lack of clarity and someone else’s money—could actually save private equity.

The same act of illusion that got us all into this mess could get private-equity firms out of it. (Actually, they might deserve their money if they can get out of this.)

Take the value, or the negative value, of the companies a P.E. firm owns. Hedge funds and banks have to re-state the value of their assets on a day-to-day basis. A private-equity firm heretofore concerned only with the trade—selling what it owns as soon as advantageously possible—suddenly becomes a benign owner. The very language of these guys changes, from “exit,” their fondest word, to “managing for the long term,” “patience,” “building.” “We’re holders,” they say. Their worthless companies become future jewels. “The market may be down, but we believe in the underlying value” … blah blah.

Then there’s the debt—the mountains of debt. The major private-equity firms are, with a little critical interpretation, like subprime-mortgage holders. In order for the banks to get the business of private-equity firms, they gave deals they should never have given. Actually, loans to P.E.-backed companies are, in many instances, far worse and far more risky than subprime loans, which at least can be foreclosed on. The major P.E. firms in the riskiest of deals have gotten the most liberal terms possible—they almost can’t go belly-up. What’s more, it is important to remember that, if the private-equity game is played correctly, you don’t have that much money in any single deal. The lenders are on the hook. (The partners at Quadrangle can wash their hands of Maxim and still show up at work the next day.) You’re not. If it does well, you benefit disproportionately; if it goes south, you suffer minimally.

More Michael Wolff on VF.com. Photograph by Mark Schäfer.

What’s more, unlike a hedge fund or a bank, which are only ever investors, a P.E. firm can suddenly become a manager (again ignoring the fact that these people know nothing about managing). They can slash, burn, reduce, maximize cash flow. Here too the language changes—from the glories of rates of return to the hard but satisfying work of management: “We’ve pulled on our boots.” Indeed, the complaint of all companies owned by private-equity firms is that, previously left alone by their remote investor-owners, they are now enduring the attention of the private-equity guys who have so much less to do (and no idea what they are doing).

As for the theoretically vast pools of capital that could, if you’re not careful, evaporate before your eyes—and therefore expose you as a bankrupt and pull you down—the way to avoid that possibility is simply not to make the call. The Carlyle Group’s $40 billion on call remains a $40 billion asset (which they brag ceaselessly about) if nobody has to deliver it up. Indeed, the only thing that you’re really calling is your 2 percent—which, on $40 billion, is $800 million. In other words, you can wait it out. You have the luxury which no one else in a panic has—you can be patient.

And then not being able to borrow. That’s tough. Except that, in a reversal of ironic magnitude, the debt that has supported private equity has so crippled the lenders that they are now selling that debt at a vast discount—and private equity is buying it. You know that $900 million I borrowed from you guys? I’ll buy the obligation back for $400 million. You get the picture. K.K.R. has started a new fund dedicated to buying other people’s debt.

What’s more, it is possible to dispense with the very notion of the private-equity business—ownership itself. Steve Rattner’s firm increasingly becomes no longer an investor but an adviser. (Quadrangle advises Michael Bloomberg and invests his money.) Rattner, in other words, having risen from the ranks of investment bankers to being an owner of corporate assets himself, is so masterful that he knows when to revert back to being a stockbroker.

The precariousness of it all is obvious to every private-equity manager—which is why they see their competitors imminently going down. One big front-page bankruptcy of a P.E.-owned company—say, Hilton, or the commercial-property company Blackstone bought from Sam Zell (enabling him to buy the Chicago Tribune, which has gone bust)—will create new demands for, and congressional oversight committees insisting on, fair accounting treatment for portfolio value. If the value of the private-equity market is re-stated like the value of the stock market (its mirror image), a reasonable panic ensues—Carlyle loses its $40 billion and everybody else can’t get at what they themselves have got on call.

And yet, being comfortable with there being no there there is the talent. That’s the private-equity genius: We’ve figured out how to buy companies without putting up the money; we’ve figured out how to run them without knowing anything about them. The situation has just gotten more fluid—the banks don’t have money to give us, and God himself couldn’t turn a profit at most companies now. But somewhere, sometime soon, if we can just bluff it out, there is opportunity. Amazing opportunity.